This article is about how to deduct expenses that occur after you buy a rental property, but before it is actually available to rent. Depending on the circumstances, this “pre-rental” period of time could be a month, or it could be years.
The Placed-in-Service Date (the “PIS date”)
A key concept when figuring startup expenses for a rental property is the placed-in-service date. It’s an important concept because expenses that are handled differently depending on whether the costs occurred before or after this date. The placed-in-service (PIS) date is the date you first make the property available for rent. So that means the property must be immediately available for move-in, and you have also publicized the availability of it as a rental in some way (Zillow, Facebook Marketplace, a yard sign, etc.). It isn’t necessarily the date the first tenant moves in, it’s just the date it was available to be rented. If you buy a property with tenants already in place, the PIS date is just the closing date of the purchase.
Deduction of expenses, depreciation, and amortization all begin on the PIS date. If the property isn’t yet placed in service in the current tax year, then you can’t yet report any expenses for the property on that year’s tax return. But keep track of your expenses, you’ll be able to start deducting those expenses started on the PIS date.
It’s generally to your advantage to place the property in service as soon as possible, so you can begin deducting expenses. There may also be other tax advantages, such as qualifying for more bonus depreciation if you eventually do a cost segregation study because the amount of bonus depreciation you can take can vary in different tax years.
For expenses that occur after the PIS date, see our article on rental expenses.
Startup Expenses That Must be Capitalized
Certain expenses that occur before the PIS date must be “capitalized” (or “depreciated”), which means you can only deduct a portion of the cost each year over a set number of years.
- The building value portion of cost of the property itself (after subtracting the land value, because land can’t be depreciated)
- Improvements or renovation made to the property
- Closing costs related to the purchase (except costs related to the loan, which have to be separately amortized over the span of the loan)
- Mortgage interest and real estate taxes paid during the time you are preparing it to be rented
- Any costs that would normally need to be depreciated while a property is in service, including purchase such as furniture and appliances that are over $2500
Most of these costs can be just added to the depreciation basis of the property and depreciated over the same period (27.5 or 39 years). But items like furniture and appliances have a shorter depreciation period (5 years) should be separately depreciated to take advantage of the shorter period.
For yearly costs like property taxes and mortgage interest, you’ll need to calculate the portion of the period that applied to the time before and after the property was placed in service. The portion before is added to your cost basis, the portion after is a deductible expense for that tax year.
Startup Expenses That May be Either Capitalized or Applied to Section 195
For some types of startup expenses, you can either capitalize them as described in the previous section, or instead you may elect to include these types of costs as section 195 startup expenses.
There are several advantages to electing to use section 195. The advantages include that you can deduct up to $5,000 of the expenses in the first tax year the property is placed in service (but that amount is reduced if you have more than $50,000 in total startup costs). And the remainder of section 195 expenses are amortized over 15 years (180 months), which is generally preferred to adding the costs to the 27.5 or 39 year depreciation basis of the property.
The difference between amortization and depreciation is that with amortization, if you sell the property before the end of the amortization period, the remaining amortization balance is deductible as an expense in that year of sale according to tax code section 195(b)(2). With depreciation, your remaining depreciation balance doesn’t become a deductible expense, but it does add to your cost basis of the sale, reducing your capital gains.
You elect to use section 195 simply by listing the expenses as current year or amortized expenses rather than depreciating them. But the election is only available to you if you file the tax return for the year by the extended deadline. Most preparers will enter the up to $5,000 portion of the startup costs under the “other” expense category, with “Startup Costs” listed as the description. Additional startup costs above the initial $5,000 are entered as an amortization asset into the tax software, which will calculate the portion to deduct as an expense each year.
Examples of these types of expenses before the PIS date that may be either capitalized or used as section 195 expenses include:
- Travel costs before the property purchase, when looking at properties in the same location as the property you bought
- Legal and accounting fees
- Travel expenses when going to the property to work on it
- Utilities
- Lawn care
- Pest control
- Regular maintenance costs
- Maintenance and repairs
- Insurance
- Furniture and other supplies that are under $2500 (assuming you make the de minimis election).
Note that section 195 specifically doesn’t allow mortgage interest or property taxes, those costs must instead be capitalized.
De Minimis Safe Harbor Election for Startup Costs
There isn’t a consensus among tax professionals as to whether the de minimis safe harbor election applies to startup costs for a business or rental property. Our current position is that it can be applied to startup costs, and that our interpretation of the tax code supports this position. But we’re not currently aware of a tax court case that has tested this position. A more conservative approach would be to not apply it to startup costs, and instead add these types of costs to the depreciation basis of the property.
Using Section 195 for Multiple Rental Properties
There is some question among some tax professionals as to whether section 195 is only applicable to startup costs for your first rental property. Under some interpretations of the section 195 tax law, it may be interpreted to mean that it can only be used when you start your first rental activity, and then startup costs for subsequent properties would have to instead be capitalized. We’re not currently aware of a tax court case that has tested this issue, but a more conservative approach would be to only use section 195 for your first rental property.
Personal Use
Most of these expenses we’ve listed can only be included if you are holding the property for the purpose of making it a rental property. If the property is not vacant, or you are using the property for personal use, then day-to-day expenses like repairs, maintenance, mortgage interest, utilities, and property taxes during that time should not be included. But if you do significant work on the property that is considered to be an improvement to the property (renovation), the cost of that can be added to your cost basis for the property that you depreciate when you convert it from personal use to a rental. Regular repairs and maintenance during the personal use period shouldn’t be included. And there are specific provisions that apply to properties that are converted from a home or personal property.
